Austerity, the ECB and Osborne

April 24, 2013

There’s been a lot of noise surrounding the rhetorical shift away from austerity in the euro zone in recent days, the notable exception being Germany. It is now widely acknowledged that monetary policy alone cannot turn economies around. But of course it has a vital part to play.

That puts the focus on the European Central Bank and growing expectations that it will cut interest rates to a new record low next month. Yesterday’s poor German PMI could have been the tipping point. On three of the four times the survey reading has fallen below 50 since the collapse of Lehman Brothers a rate cut followed the month after. Germany’s PMI duly slipped into contractionary territory yesterday.

In all this, we shouldn’t lose sight of the fact that a quarter-point rate cut may move markets but will have only a small impact on the euro zone economy. It’s also true that the ECB has shown no signs of wanting debt-cutting drives to be mothballed. Its reaction to any shift in that direction remains to be seen.

Germany’s Ifo sentiment index will give another readout on the latest state of play in Europe’s largest economy and we have a host of key policymakers speaking – Angela Merkel and Bundesbank chief Jens Weidmann in Germany and ECB vice-president Constancio delivering the central bank’s annual report to the European Parliament. He said earlier this week that inflation had fallen “rather significantly” and a rate cut was “always a possibility”. Eurogroup chairman Jeroen Dijsselbloem appears in the Dutch parliament.

Hopes that an Italian government will soon be formed have driven euro zone peripheral bond yields lower this week, to levels not seen since 2010. Today, newly re-elected president Napolitano will announce his choice of prime minister, having apparently secured the backing of both the centre-left and centre-right. It’s a big moment. 75-year-old Giuliano Amato is the favourite and the sort of figure who will persuade investors that there aren’t any policy shocks around the corner.

Given that, one of the biggest achievements the new government could notch up would be a change to the electoral law to prevent the sort of deadlock that resulted from February’s election. Rome also sells zero coupon and inflation-linked bonds. Even in the most uncertain times it has sold debt without a hitch this year so there’s no reason to suppose today will buck the trend.

German Bund futures, the traditional haven in times of stress, have fallen at the open with all eyes on Italy. European stocks look set to open higher.

There is a growing feeling in Brussels that all the euro zone debt crisis skeletons are now out of the cupboard. That doesn’t mean the crisis is over but policymakers are increasingly confident there aren’t any more black swan moments to derail them. The glaring gap in the currency bloc’s defences is the lack of a banking union and progress on that front has pretty much stalled but there’s no denying that the threat of euro zone breakup has shriveled.

At the crack of dawn, Britain produced its latest gambit to kickstart the economy – extending its funding for lending scheme, whereby banks and other credit providers can access 10s of billions of pounds of cheap credit from the Bank of England if they commit to lend it on, for a further year through 2014 with the focus firmly on smaller companies. The problem is that the programme has had only lukewarm effects on lending so far. Cynics suggest that finance minister George Osborne is seeking to appease the IMF, which is urging a change of tack from his austerity drive and will deliver its annual report on the UK next month. Turning up the cynicism dial a notch, is it possible the government is acting in advance of Q1 GDP data tomorrow which, if they contract, will show Britain has succumbed to a “triple dip” recession?

Economically, it’s small beer but politically a return to recession would be huge. Osborne is also in the increasingly uncomfortable position of being one of the only flagbearers for debt-cutting anywhere in the world. Germany can afford to beat that drum because it’s economy is so much stronger.

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